The SNB's interest rate policy has brought the boom in demand for apartment buildings to an abrupt halt in 2023. What does this mean for pension funds? And will prices rise again after interest rate cuts? Various experts explore these questions.

Until recently, residential real estate was a good investment for pension funds: it provided long-term value appreciation, stable rental income and higher returns than federal bonds. It is therefore no wonder that apartment buildings were popular with pension funds during the low interest rate era; it is also no wonder that the proportion of real estate in investment assets rose steadily. But it is also no wonder that the turnaround in interest rates left its mark on the market and on portfolios.

Prices for residential real estate have fallen in 2023

In fact, prices for residential properties fell by around 4.4% in 2023, says Dr. Robert Weinert, Head of Research at Wüest Partner. In addition, the transaction volume for Switzerland as a whole was around 35% below the long-term average last year. However, the real estate experts at UBS put this into perspective: Quality-adjusted transaction prices have risen by around 36% overall since the beginning of 2013 - particularly strongly in 2022. The 2023 value loss of 4.4% is therefore not quite half of the increase in the previous year. Weinert attributes the strong growth up to the first quarter of 2022 to the fact that many institutional investors were still in an investment crisis until immediately before the interest rate turnaround, meaning that the willingness to pay for real estate continued to rise sharply despite already high prices.

Following the interest rate turnaround in the second quarter of 2022, some pension funds strategically optimized their portfolios. As a result, the properties traded immediately after the interest rate turnaround were somewhat smaller and of lower quality - the average transaction in 2022 was 15% below the long-term average. Compared to the second half of 2022, fewer but higher-quality apartment buildings were traded in 2023, as the UBS experts explain.

So have pension funds not lost any money on real estate in 2023?

Both Robert Weinert and Claudio Saputelli, Head of Global Real Estate at UBS CIO, as well as Patric Caillat, Fund Manager at UBS Investment Foundation, are of the opinion that this may well have been the case. They cite various reasons for this. For example, pension funds pursue a long-term buy-and-hold strategy with their direct real estate investments; they do not behave like other, more buy-and-sell-oriented investors. A loss was therefore only incurred if a pension fund bought a property in 2022 and sold it again in 2023.

Pension funds would also finance real estate from their own funds. Rising interest rates for borrowed capital would therefore not have a negative impact - on the contrary: pension funds could apply the higher reference interest rate to their portfolio rents and thus increase their return on capital.

Pension funds also prefer residential properties for their direct investments because they are less volatile than office and retail space; with a significantly lower vacancy risk, they offer stable rental income and thus enable more precise liquidity planning.

Interest rate cuts will have an impact on the mortgage reference interest rate

In view of low inflation, for Saputelli the question is not whether the SNB will lower its key interest rate in 2024; it is more a question of when and how much. Saputelli expects three interest rate cuts (the first was on March 21) and anticipates an interest rate of 1% by the end of 2024.

These interest rate cuts would also affect the mortgage reference rate with a certain delay, as he explains, although both he and Weinert assume that this will remain at the current level of 1.75% until at least the end of 2024. According to the experts, a further increase to 2% is unlikely (but cannot be ruled out if, contrary to expectations, inflation significantly exceeds the 2% hurdle). Money market mortgages would react more directly to interest rate hikes, but this would have no impact on the reference interest rate.

Concrete gold or Swiss Confederates?

According to the experts, Swiss pension funds have tripled their real estate investments over the last 15 years, partly as a result of the growing investment capital of the pension funds, but also due to the SNB's low interest rate policy. In the meantime, a positive yield can be achieved again with 10-year Confederation bonds, whereby the expected reduction in the SNB key interest rate has already been priced into the prices of Confederation bonds: at the end of February 2024, the yield for Confederation bonds was 0.92%; UBS still expects 0.7% at the end of 2024. In contrast, the median net initial yield on apartment buildings was 3.1% last year.

Falling key interest rates are likely to lead to rising transaction volumes for residential real estate and thus to falling net yields. However, Weinert does not expect another strong price rally in residential real estate. He sees the reason for this in the still high proportion of real estate in most pension fund portfolios.

A number of pension funds had a real estate ratio of up to 50% at the end of 2022

Falling share prices lead to a relative increase in the proportion of real estate, which is limited by the BVV to 30% of the total portfolio. According to a study conducted by the consulting firm Complementa in July 2023, one in three Swiss pension funds had a real estate ratio of up to 40% at the end of 2022 and one in fifteen even up to 50%.

In the meantime, the majority of real estate ratios should be back in the green in 2023 (also) thanks to the stronger stock markets, the experts estimate. And they know: There were pension funds that had to sell real estate investments in order to stay within the bandwidth - not least in an illiquid market with a 30% lower transaction volume compared to the previous year. They were therefore forced to sell the most liquid of their illiquid assets - for example, units in listed real estate funds that were already on a dive. According to the experts, redemption fees, which many real estate funds and investment foundations increased - also to protect their investors - had an additional negative impact on earnings. The experts explain: «Pension funds have learned from such experiences. It can therefore be assumed that they will continue to optimize their real estate portfolios in a targeted manner, but will no longer increase them close to the 30% limit.»